Forecasting is becoming more difficult and less reliable for business planning purposes. Forecasting models are typically developed using historical patterns of behavior and of related events. There is often an unspoken ceteris paribus assumption that all things outside of the model hold constant but this is far reality.
In periods when exogenous forces of change move relatively slowly, such forecast models produce acceptably reliable projections. But the pace of change in exogenous forces affecting business has been increasing rapidly. These exogenous forces of change are increasingly impacting the effectiveness of planning in both the long-term and short-term.
The demand volatility that results leaves us with a choice: We either accept the risks of unexplained variation in our forecasts or adopt hedging strategies and plans that mitigate their effects. Hedging is a means of mitigation in the face of uncertainty. While hedging short-term risk across the company’s functional areas is important, hedging of long-term risks is essential to the very existence of the business. As with every business initiative there is a trade-off. Here it is the cost of hedging risk vs the benefit to be realized from the hedge. So, what are hedging strategies?
Types of Supply Chain Hedging Strategies
In Finance, for example, hedging is a risk management strategy employed to offset losses in investments by taking an opposite position in a related financial asset. In supply chain activities, hedging is often done trading in the commodities options markets to reduce the effects of price fluctuations in essential materials used to make the company’s products.
Insurance products are also an example. If a company buys property insurance, it is hedging itself self against fires, weather, or other unforeseen disasters. Similarly, this is the case with key-man insurance and officer liability insurance in business. In demand planning and supply chain forecasts and plans, inventory is often used as a short-term hedging strategy for uncertainty. Supplier selection and diversification can also be a hedging strategy. Some risks are insurable, which diversifies the risk sharing. Some risks are not insurable. So, portfolio managers, individual investors, and corporations use hedging techniques to reduce their exposure to various risks that they cannot directly control.
Identification of exogenous risk factors requires participation of experts from all areas of the business
Executive and senior management are responsible for the strategic and long-term plans of the company and for implementing hedges to deal with risks that exist within these plans. The first step in developing hedging strategies is to determine which forces of change are significant and are materially increasing financial, operational, or other short-term and long-term risk. Identification of significant exogenous factors requires participation of cross-functional members who are experts in the risks related to sales, marketing, operations, product development, demand planning, supply chain, inventory management, distribution, finance, and other key functional areas within the company.
Since these functional areas have unique risk characteristics but also affect each other, it is important to approach the question of material risks in a holistic manner. Any business forecasting and planning efforts will need to consider hedging strategies as they relate to the functional areas individually and collectively. So, structuring a process of cross-functional involvement is important to precluding siloed efforts which do not assess the cross-functional interaction of risk.
Risk assessment is usually initiated by executive management and undertaken by senior management across the functional areas
This risk assessment process phase generally happens as part of the strategic and long-term planning of a company. It is usually initiated by the executive management and is undertaken by senior management across the functional areas. The demand planning and supply chain functions are involved along with other functional areas, but the purpose is to orchestrate and integrate the risk assessments and hedging actions across the company. Finance and FP&A are heavily involved due to the monetization activity that is a part of this effort. Naturally, the finance functions of the company are usually an important part of the higher-level, long-term planning for which senior and executive management are responsible.
Exogenous Risk Categories
Each functional area should develop a list of exogenous risk categories that characterize their functional responsibility. These broad categories could be technological, environmental, competitive, political, financial, demographic, economic, market-related, etc. Within these broad categories, specific significant risks both short-term and long-term can be identified along with the degree of risk (e.g., extremely high, high, medium, moderate), expected effects and results, associated potential costs or profit loss, as well as potential hedging actions that may be considered. Hedging actions should consider resources required and potential costs and benefits of the hedging activities necessary to offset or partially offset the risk.
It is important that FP&A be involved to dollarize risks and actions
It is important that each participating functional area shares its results and findings with the other participating functional groups. Their coming together as a group to review and integrate their combined risk assessments is important in being able to prioritize different risks, assess the collective business effects, determine which can be hedged and to what degree, and to develop a plan of action that addresses the timely hedging of the most significant risk areas. It is important that FP&A be involved to dollarize risks and actions as well as support all of the functional areas in the translation of their findings into financial effects and financial plans.
Real-Life Examples of Hedging Risk
Example 1: Business Software
Let’s look at a real-world example. There is a global business systems company for which the R&D/Product Development function develops operating systems, hardware, and software for sale to multiple business types globally. The company funds these undertakings from an R&D budget that is funded as a percentage of corporate revenue. It was working on a replacement for an existing retail software product that had a tight introduction timeline given the existing product was close to the end of its lifecycle. Designing the replacement solution was complicated because there were multiple types of technology that could be used to build it. This presented uncertainty both in terms of performance and cost to build and roll out the replacement system.
So, the company hedged the technology risk with a multi-path development approach, starting three alternative projects simultaneously, from which the company would select the best option. There were periodic assessments of each project to evaluate progress. A date for a decision was set and, based on the findings, a final technology solution and product design was chosen from the three options and carried through to completion, abandoning the other two projects that did not make the cut.
This allowed the company to meet the market window timeline that was so important to the product introduction, and to choose the best technological alternative to ensure acceptance and product longevity in a competitive marketplace. The cost of the three projects was more than offset by the additional revenue and profit realized by hitting the market introduction window and in having a competitive technology solution.
Example 2: Food Service Industry
Another real-world risk hedge example is from the Food Service industry. There is a large midwestern restaurant industry corporation that had a growth plan for expanding its market penetration through a combination of franchising and company unit market development. It was a publicly traded company on the New York Stock Exchange, and its value in the market was materially influenced by investor expectations for the success of the growth plans of the company.
The company used regional vendors for getting supplies to the restaurant locations and would continue to expand this supply chain as market expansion continued. But there were signature products that were absolutely essential to the financial success of the restaurants, especially as expansion took place into new markets. Insufficient availability of these signature products from third party vendors as expansion occurred was a major risk to the success of the expansion plans.
So, to hedge the long-term Signature Product Risk, the company purchased a food processing operation in a strategic location in the geography of the growth area. The company would operate and control the food processing plant and its operations. It had the capacity to service all of the current locations as well additional locations as market expansion continued. It also had the potential to expand its processing capacity if market expansion exceeded currently planned levels.
As it turned out, this processing plant met market needs for a long period of time and supported the growth strategy, and even went on to expand its capacity as the company went beyond the original expansion plans. This provided a flexible and expandable hedge for the Signature Product Risk that could have affected the company brand positioning, the financial success of the restaurant operating units, and the success of the business expansion programs.
Top management support, buy-in across functional areas, and translating results into activity and financial plans is essential.
The best forum in which to drive the risk assessment and hedging efforts described above is the long-term business and strategic planning of the company. Top management support, buy-in across functional areas, and translating results into activity and financial plans is essential. It can add to the quality and effectiveness of the long-term and strategic planning processes in which senior and executive management is involved. It provides a framework for functional risk analysis, and hedging can be done for short-term risk hedging across the company’s functional areas.
The Bottom Line
As the speed and degree of change continues to become more of a factor in business forecasting and planning — both short-term and long-term — company success and survival will require processes that are adaptive by nature to the risks that are affecting all businesses today. Hedging strategies are an important consideration in this increasingly volatile business environment. Assess the risks in your business forecasts and plans. Expect the unexpected. And hedge your bets.
This article first appeared in the fall 2023 issue of the Journal of Business Forecasting. To access the Journal, become an IBF member and get it delivered to your door every quarter, along with a host of memberships benefits including discounted conferences and training, exclusive workshops, and access to the entire IBF knowledge library.